AMMAN STOCK EXCHANGE BUBBLE: WIDER DANGER FOR

C O N F I D E N T I A L SECTION 01 OF 05 AMMAN 002776 SIPDIS TREASURY FOR ADAMS E.O. 12958: DECL: 03/04/2015 TAGS: EFIN ECON PGOV KPAL JO SUBJECT: AMMAN STOCK EXCHANGE BUBBLE: WIDER DANGER FOR JORDAN'S ECONOMY? REF: A. AMMAN 1087 ¶B. AMMAN 2295 ¶C. AMMAN 2050 Classified By: Charge d'Affaires David Hale for reasons 1.4 (b),(d),a nd (e) ¶1. (C) SUMMARY: A dramatic rise at the Amman Stock Exchange (ASE) over the past two years has both reflected and reinforced the Jordanian economy,s healthy growth since the 2003 coalition invasion of Iraq. The ASE was one of the best performers in the world over 2004, turning in one of the best year-on-year performances in its history. Market growth so far this year has been even more remarkable. Factors contributing to the increase include foreign capital, the entry of many small domestic investors (spurred by USAID-supported improvements to the structure of the market), and the contining influx of pension money. However, the traditional mainstay of the market - banks and large private investors - appear to be the primary drivers of the recent increase in share prices. Some analysts, sanguine that the increase reflects strong fundamentals and corrects earlier undervaluation, predict relatively flat growth and possibly a slight correction over the next two years, but major investors - and increasingly, the rest of the market - are more leery of the current market valuations. To us, the ASE's current levels look like a bubble ready to burst, and we predict that the trigger might have something to do with the Arab Bank, which makes up roughly one third of the ASE's capitalization. END SUMMARY. -------------- A BANNER YEAR -------------- ¶2. (U) When, at the end of 2003, brokerage figures showed the ASE index to have jumped almost 55% over the year, many Jordanians predicted a sedate 2004. They were wrong. The ASE in 2004 turned in the second-best one-year performance in its 25-year history. With an index growth rate of over 62% for the year, the exchange was one of the best-performing in the world. It held its own even against stock exchanges throughout the Middle East, many of which had all-time record years for index growth in 2004. The vast majority of the 2004 price rise came in a three-month period stretching from the end of September 2004 until the end of the year; the market has increased more than 30% so far in 2005 and the index now stands at a valuation double that of the already high level it had attained 52 weeks ago. -------------- MONEY FROM ABROAD? -------------- ¶3. (U) The popular explanation in Jordan for the dramatic rise in stock prices - as for rises in other prices, from real estate to foodstuffs - has been Iraqi money. Iraqis fleeing their war-torn country, according to this theory, are parking their money in any kind of asset they can find - and ASE-listed stocks are attractively liquid, easy to sell off in order, for instance, to ransom a relative. We have heard versions of this theory from everyone from analysts to large investors to bank presidents to GOJ ministers. ¶4. (SBU) While this theory attractively conforms to Jordanian perceptions of Iraq and of the Iraqis in Jordan, it does not conform well to reality in the case of ASE prices. While it is true that foreign entities and individuals hold just over 40% of the total value of the ASE,s market capitalization, the vast majority of it is in the hands of long-term investors and strategic partners, almost none of whom are Iraqi. These investors prominently include Kuwaiti, Saudi, and Lebanese investors who hold large stakes and seats on the boards of most of Jordan,s banks, and the French and Canadian companies that have taken large stakes in Jordan,s privatized telecom and mining corporations. Market analysts estimate that no more than 6% of the market is made up of foreign "hot money" - a percentage which has not grown significantly over the course of 2004. -------------- ENTRY OF THE COMMON MAN? -------------- ¶5. (SBU) An alternative explanation is posed by several market insiders. According to these investors and analysts, the combination of the substantial 2003 bull market and changes in the structure and rules of the ASE (to which USAID gave substantial technical support) have fostered a deep interest in the stock market among the "common man." Particularly significant among these changes, some say, was the new ASE rule requiring publication of quarterly reports for all listed companies. One analyst notes that the beginning of the massive rise at the end of 2004 almost exactly coincided with the publication of the first-ever mandatory quarterly reports, which provided a level of transparency not previously available and at the same time showed the sharp profitability growth that Jordanian companies had experienced over the previous six months. Several analysts and investors had stories of taxi drivers, housewives, and other nontraditional investors who now would converse only about the market and its prospects. ¶6. (SBU) Optimists, who include most of the younger analysts to whom we talked, see the entry of more small investors as a long-term inflationary trend that will only grow in the future, giving the market a higher "natural" valuation as investors grow comfortable and eliminate part of the risk premium. The larger number of small investors is a healthy sign and could be a stabilizing force in the market. Some brokers, however, regard the entry of small - and largely uninformed - investors into the market as an alarming sign that the ASE is now a full-blown bubble. ¶7. An adjunct to the "small investor" theory of the ASE rise notes the role of Jordan,s Social Security Corporation (SSC). The SSC is prohibited by law from investing anywahere but in Jordan. Its stakes are primarily strategic, but its large surplus (resulting from Jordan,s population structure) ensures that more money is constantly flowing into all of its investments, approximately half of which are equities traded on the ASE. The SSC,s holdings make up around 11% of the total capitalization of the market, slightly up from 2003, with an overall valuation of JD 1.7 billion ($2.4 billion). While its investments in the market remained statutorily capped and its active portfolio (JD 30 million = $42 million) is in relative terms quite small, the constant stream of money entering the market on a predictable basis adds a long-term inflationary force to the stock market. -------------- A SHORT-TERM SHIFTING OF CAPITAL -------------- ¶8. (SBU) While the entry of small investors is beginning to change the face of the market, however, its input on market movements has to date been relatively limited. The overwhelming proportion of non-strategic investors are the same large-scale individuals and institutions who have traditionally been the major players in the ASE - and who have now simply decided to allocate more of their capital to portfolio investment. While the excellent recent profitability of many ASE-listed companies and the above-mentioned increase in the ASE,s transparency drive some of this reallocation, short-term regulatory decisions and the peculiarities of Jordan,s financial system are also contributing factors. ¶9. (SBU) The low interest rates maintained by the CBJ (following the Fed,s lead) over the past several years have been one such factor. Many investors who traditionally have held large balances in deposit accounts have come to believe that their returns were destined to remain smaller than the inflation rate. Meanwhile, the large spreads maintained by the oligopolistic behavior of Jordanian banks have reduced the returns for investors wishing to fund productive projects with the assistance of borrowed capital and have maintained depositors, interest rates at a low level even after recent rises in CBJ interest rates. The result has been a flight to assets such as stocks and also real estate, which has similarly experienced a superb recent performance. ¶10. (U) Another regulatory decision contributing to the shift of capital by major market players into the ASE has been the CBJ,s requirement that all banks raise their paid-up capital to JD 40 million ($56.4 million) by the end of 2005 (ref A). The order, meant by the CBJ to spur a wave of mergers, instead has led many banks to hold private offerings of extra shares at reduced prices to their shareholders. The constant stream of offerings have created substantial excitement the market, by creating the impression among stockholders that they were receiving "inside" deals, and prompting those not already invested in banks to pile in. The fallout from this dilution of shares has not yet become apparent, as excitement - and share pricing - remains high after the private offerings launched by many of these banks. -------------- CAN IT LAST? -------------- ¶11. (U) Virtually every analyst with whom we have spoken is willing to predict moderate growth over 2005, despite the substantial run-up of the last two years. One reason for this prediction is the considerable growth in profitability that large sectors of the Jordanian economy has realized over that period. This profitability growth has been most pronounced in the industrial and transportation sectors, but the resurrection of tourism to Jordan has vastly improved returns to that sector - a long-term improvement likely to become even more pronounced over the coming year, in part due to events in the region (septel). ¶12. (U) More convincingly, market optimists point to other factors that have little to do with market fundamentals. The ASE in 2005 is likely to see several events that will heighten the excitement of investors. Several major IPOs are planned for 2005, to include (definitely) Fastlink, Jordan,s dominant mobile telephony operator and one of the most profitable firms in Jordan, and (possibly) all or parts of the Nuqul Group, the paper-products and consumer-goods empire belonging to the richest man in Jordan. Sales of all or parts of the GOJ shares in major corporations such as Jordan Telecom and the Jordan Phosphate Mines Company will likely add to the attractiveness of these major Jordanian companies while adding volume to the market (ref B). Jordan,s Palestinian community is excited by the probable listing of Palestinian Territories, two corporate heavyweights, the Palestinian Development and Investment Corporation (PADICO) and the Palestinian Telecommunications Corporation (PALTEL) on the ASE in late summer/early fall of this year. ¶13. (U) Most anticipated of all, however, is an upcoming 10-for-1 split in Arab Bank,s stock. The most respected Palestinian corporation and a reliable engine of profit for over seventy conflict-ridden years, Arab Bank currently boasts a stock price so high that, combined with the Bank,s minimum purchase limit (20 shares),it excludes any investor unable to put up JD 6,050 ($8,530) or more. The radical split of this stock will finally open it up to small investors looking for a safe bet. Market optimists see hundreds of millions of dollars flowing into Arab Bank stock from Palestinian small investors around the world - and the upward rise of Arab Bank stock, which makes up over a third of the ASE,s overall capitalization, can be expected to inexorably pull the market with it. -------------- PERHAPS NOT -------------- ¶14. (C) This optimistic view, however, is far from universal; indeed, it seems to be taken primarily by younger analysts and by people who have recently entered the market. The view of those who actually have the potential to affect market movements, on the other hand, is more grim. Since the beginning of 2005, we have been hearing a steady drumbeat of negativity on market valuations from major investors and bank presidents; recently, assessments from this group have taken on a tinge of alarm. These assessments are echoed, with a bit more finesse, by Henry Azzam, a well-respected commentator on the market and head of the Jordinvest brokerage house. Azzam told us privately in February that he looked forward to a fall in the market because it would force investors to find productive uses for their capital rather than adding to the inflation of asset prices. Recently, he has gone public with his worries, arguing in a column syndicated in newspapers throughout the Arab World that the CBJ should raise interest rates until the ASE bubble is pricked. ¶15. (U) Market pessimists point to several hard facts of the market as justification for their outlook. The ASE,s total valuation currently stands at around 220% of Jordan,s GDP, one of the highest rates in the world (for sake of comparison, the valuation of the NYSE is just over 100% of US GDP). This figure is not significantly above the relative valuations of the exchanges in several GCC countries; however, Jordanians doubt the rationality of the GCC exchanges, valuations as well, and the oil-fueled GCC economies have seen sustained growth over the past three years that Jordan,s economy has not even approximated. It is significantly above any level ever reached in the history of the ASE; at the market,s last peak, in 1993, its valuation stood at 90% of GDP. ¶16. (U) Productivity growth alone does not account for the state of the market; in fact, the average P/E ratio of stocks on the ASE is at its highest level in history, around 25 (average P/Es for stocks in emerging markets worldwide generally fall in the range of 14-15). Many of the best-performing stocks listed on the ASE are those of financial companies, whose performance has been inflated by paper gains from their investments in the ASE itself. All signs seem to point to a market at a cyclical peak, last reached in 1993 and prior to that in 1981-2. The difference this time around is the unprecedented size of the peak. -------------- COMMENT: AS GOES ARAB BANK... -------------- ¶17. (C) The market may, in fact, have already peaked. In its most recent expansionary phase, from October 2004, it has moved almost in lockstep with the share price of the Arab Bank. Arab Bank, in turn, has risen steadily (though not without a few hiccups - ref C) ever since the announcement of its plan for a 10-for-1 split, to be implemented in the upcoming week. Of late, however, the stock has fallen approximately 7% off of its high, achieved two weeks ago. The ASE, taking its cue, has drifted down slightly over the same period. The market appears to feel that the expected influx of small investors into Arab Bank stock has already been priced in (Arab Bank stock is, after all, currently trading at a jaw-dropping P/E of 37); the upcoming week should show whether this perception is correct. ¶18. (C) There is reason to believe, at least on the basis of recent market activity, that the market could deflate relatively gently by itself, perhaps aided by some prodding from the CBJ. CBJ Governor Umayya Touqan told visiting Senator Gordon Smith March 20 that he hoped to help create a "soft landing" for the ASE. CBJ Deputy Governor Faris Sharaf confirmed to econoff that the CBJ is concerned with the problem and is trying to signal the market to slow down; the CBJ,s press release on March 26 announcing the most recent round of interest rate increases included for the first time language about the high valuation of asset prices in Jordan. Without any serious outside shocks, excitement generated by new IPOs and stock sales may help to slow the pull of gravity and to ensure a soft landing for the market. ¶19. (C) An absence of external shocks, however, may be an heroic assumption. Jordan is famously an oasis of calm in a bad neighborhood, but it is hardly immune to its neighbors' troubles. A single successful terrorist attack could reverse perceptions and provoke a small capital flight that might snowball, given existing fears about the outsized market valuations. The market is similarly vulnerable to the prospect of a sudden loss of confidence in Arab Bank, the major market mover, possibly sparked by events in the U.S. - e.g., a large judgment against the bank in the New York civil suits filed against it, or a problem in securing an inflow of U.S. dollars if the bank were unable to secure a clearing agent for its New York operation. ¶20. (C) If a sharp shock were to cause panic selling, concern for the future of the ASE would be in order. The market optimists are correct when they talk about the entry of the small investor, though perhaps not about the small investors, importance in market movements. For the first time, the ASE has real resonance among Jordanians outside of the traditional, closed circle of market insiders - a real triumph both for the GOJ,s reform agenda and the USAID technical assistance that has backed it to the hilt. The benefits of this market broadening are self-evident, but its dangers may become more evident in the event of a sudden drop in the market. Primary among these dangers is the possibility that small investors would see a drop in a market so highly touted as a success story as a betrayal of their interests. Despite all of the past few years, reforms in the transparency of the market - and they have been substantial - the primarily family-based holding structure of the firms that make up most of Jordan,s economy leaves the market highly vulnerable to insider trading. In a sudden price collapse, therefore, many of the major investors would likely emerge relatively unscathed while the small investors were left holding the bag. If this were to happen in a relatively public way, it might be some time before the public would recover confidence in the market - or in the forces that backed it. ¶21. (C) The wider effects of such an ASE price collapse on the economy of Jordan as a whole would also likely be significant. Leaving aside the heavy exposure of the Social Security Corporation to the ASE, there is reason to worry about the banking sector. The CBJ has begun to calculate the amount of borrowed money currently in the market, and has come up with a back-of-the-envelope figure of JD1-1.3 billion ($1.4-1.8 billion),almost all of which the CBJ believes has entered the market over the past year. Given that the size of Jordan,s GDP in 2004 was $10.8 billion, there would seem to be a dangerously high level of bank exposure to the vicissitudes of the market. A sudden fall in the ASE could well put several of the more retail-focused banks - especially those with large portfolios of their own in the ASE. The result of one or more bank collapses concurrent with an ASE asset price collapse would be difficult to predict with exactitude, but the likely cost to Jordan,s "real" economy would likely be high. HALE